FINANCIAL MARKETS

Well-functioning, liquid and resilient financial markets help monetary policy transmission as well as in allocation and absorption of risks entailed in financing India’s growth.

Major market segments under the regulatory ambit of the Reserve Bank are interest
rate markets, including Government Securities market and money markets; foreign
exchange markets; derivatives on interest rates/prices, repo, foreign exchange rates
as well as credit derivatives.

Broad Regulatory Framework and Instruments

The Reserve Bank derives statutory powers to regulate market segments from specific
provisions of the Reserve Bank of India Act, 1934. The prudential guidelines issued
to eligible market participants form the broad regulatory framework for Government
securities, money market and interest rate derivatives.

Government securities market: The Government securities market, which trades
securities issued by Central and State Governments, has seen significant growth
in the last two decades. It has a sizeable primary and an active secondary segments.
Trading largely takes place on the Negotiated Dealing System-Order Matching (NDS-OM),
an anonymous order-matching trading platform. The average daily trading volume in
Government securities market has shown significant growth from Rs.32.15 billion
in 2005-06 to Rs.433.12 billion in 2014-15. All the secondary market transactions
in Government Securities are settled through a central counterparty mechanism under
Delivery Versus Payment mode. Multilateral netting is achieved with a single funds
settlement obligation for each member for a particular settlement date. The settlement
is achieved in the RTGS (Real Time Gross Settlement) Settlement/Current Account
maintained by the member in the Reserve Bank.

Call money market: Uncollaterised call money market is restricted to banks
and Primary Dealers subject to prudential limits. The collaterised segments include
Collaterised Borrowing and Lending Facility (CBLO) and market repo transactions
between banks and financial institutions. The money market also includes Commercial
Paper (CP) issuances by corporates, PDs and financial institutions and Certificates
of Deposit (CD) issued by banks to institutional investors. Detailed guidelines
on each segment of the money market are available under the section Master Circulars
for financial markets on this website.

Foreign exchange market: In the foreign exchange market, the Foreign Exchange
Management Act, 1999 (Act 42 of 1999), better known as FEMA, 1999, provides the
statutory framework for the regulation of Foreign Exchange derivatives contracts.
Residents can hedge their foreign exchange exposures through various products, such
as, forward contracts, options involving rupee and foreign currencies, currency
swaps and cost reduction option structures in the OTC market. Foreign investors
can also hedge their investments in equity and/or debt in India through forwards
and options.

In addition, trading within specified position limits is permitted on exchange traded
currency futures in four currency pairs and in USD for currency options. Residents
are also permitted to hedge their commodity price risk, as per specific guidelines,
in the overseas OTC markets and exchanges.

Over the years, the foreign exchange spot as well as forward market has expanded
quite significantly. The average daily forex market turnover has grown from approximately
USD 16 billion in 2005-06 to nearly US$ 55 billion in 2014-15. The average daily
trading volume in the inter-bank USD/INR forwards was at USD 6.43 billion and that
of the USD/INR futures was at USD 2.64 billion during the financial year 2014-15.

Derivatives: In the OTC interest rate derivatives (IRD) segment, interest
rate swaps (IRS) and forward rate agreements (FRA) are permitted on various benchmarks
where banks and primary dealers (PD) take hedging and trading positions. Other regulated
entities like insurance companies, mutual funds, Non-Banking Finance Companies can
participate in IRD for the purpose of hedging. The activity in IRS market has shown
impressive growth with the average daily inter-bank trading volume (notional principal)
in Rupee IRS at Rs. 88.60 billion in financial year 2014-15. In addition, there
are exchange traded interest rate futures (IRF) which are also open to Foreign Portfolio
Investors (FPI). Trading activity in the IRF market has picked up in the recent
period with average daily trading volume of Rs. 19.18 billion during the financial
year 2014-15.

Implementation of OTC Market Reforms

India is committed to implementing OTC derivatives reform measures recommended by
G-20/Financial Stability Board and has initiated steps for adoption of these reforms.
India was one of the few countries having a formal framework for regulation of OTC
markets even before post-crisis, the focus shifted to this area globally. The ongoing
efforts focus on improving transparency and reducing counterparty risk in the OTC
derivatives markets and fostering development of robust market infrastructure for
trading, settlement and reporting of transactions.

Against this backdrop, the trade reporting arrangement for various OTC interest
rate, foreign exchange and credit derivatives has since been completed. The arrangement
covers the Rupee IRS/FRA, FX Forwards, Options and Swaps, Currency Swaps, IRS/FRA
in foreign currencies and CDS. India is fully compliant under the G-20 commitment
of reporting OTC derivative transactions.

Central Counterparty (CCP) mechanism has been put in place for IRS, forex forward
and swaps. In principle approval has been given to Clearing Corporation of India
Limited (CCIL) to develop the anonymous trading platform with CCP facility for IRS
trades.

Looking Ahead

The core objective of the Reserve Bank’s regulations for financial markets is to
develop safe and stable market which provides appropriate products for trading and
risk management. As part of this approach, it is sought to remove structural rigidities
for better price discovery and increasing both the depth and width of the financial
markets. Efforts are on to develop and strengthen inter-linkages between market
segments, fostering competition, increasing menu of choices through innovations
in products and market practices. Regulatory, legal, institutional and technological
infrastructure is also being strengthened for orderly market activity.

Improving the liquidity of the G-sec markets remains a priority. Possible ways to
revitalise market-making by PDs are being examined. In order to broad base the participation
in IRS and reduce settlement risk, an anonymous electronic trading platform is to
be launched shortly. Taking into account the feedback received from the market,
it has also been announced to introduce new cash settled IRFs on underlying securities
with residual maturity between tenor 5-7 year and 13-15 year.

The foreign exchange market needs more products to help participants manage their
foreign exchange risk. Foreign portfolio investors (FPIs) have now been granted
access to the domestic exchange traded derivative markets. Further rationalisation
of the operational procedure is being considered. Over the medium term, extending
access to the OTC market to international stakeholders could also be considered.
Besides, options market could be expanded over the coming years to allow market
participants to hedge more easily and cheaply.

Legal Framework

In order to ensure the robustness and credibility of the financial system and to
minimise the risks, the Reserve Bank has designated industry bodies Fixed Income,
Money Markets and Derivatives Association of India (FIMMDA) and Foreign Exchange
Dealers Association of India (FEDAI) as the benchmark administrators for the Rupee
interest rate and foreign exchange benchmarks, respectively. The FIMMDA, FEDAI and
Indian Banks Association (IBA) have since jointly floated an independent company
for benchmark administration. Benchmark submission activities of banks and PDs including
their governance framework for submission are proposed to be brought under the Reserve
Bank’s on-site and off-site supervision

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